Intro to Econ: Ninth Lecture Aside – Moral Hazard

I want to briefly come back to the problem of whether you get a loan for your project under the assumption that the risk inherent in your project is stochastically independent of other investment risks. So this was our problem (see also here and here):

$\begin{tabular}{c|ccccc} Scenario & Income & Probability & you get & investor gets \\ \hline good & 200.000 & 80\% & 200.000-x & x \\ bad & -50.000 & 20\% & 0 & -50.000 \\ \end{tabular},$

where $x$ is the repayment amount that you pay back to the investor in case of the project being successful. We argued (in a previous post) that the range of feasible interest rates is 12,5% to 200%. Anything outside that will certainly not be accepted by either the investor or by you.

Suppose that you and the investor are close to agreeing to an interest rate of almost 200%. Put yourself in the shoes of the investor for a moment. What might worry you in this case?

Well, if I were the investor I would realize that you have very little to gain from the success of the project if we indeed agree a 200% interest rate. You may recall that, in the very beginning, we said that the project required two things: startup money that you need to raise somehow and a lot of work from you. So I would then worry that, given that you have little to gain from the success of the project, you will not try very hard to make the project a success. And if you don’t try very hard I might have to revise my assessment of the likelihood of a successful outcome downwards. This new risk that I, as your investor, am now facing is often called “moral hazard”.

I believe the term comes from the insurance industry who face moral hazard for instance when they insure you against burglaries and then you stop locking your house when you are on holiday. Well, you might not do something quite as extreme – and in fact the insurance contract details will state that in such cases they do not cover your damages – but you might not do everything to help prevent burglaries that you would do if you were not insured. Or when you have full coverage car insurance you might not be quite as careful with your car as you would be if you had only the basic insurance. The term moral hazard is used more generally in economics whenever there is a contractual arrangement between two or more parties, in which the two parties do not have exactly the same interest and the contract cannot completely specify (or this cannot be enforced) what one party wants the other to do. If, to just give one example, you employ a cleaning person, this person might not care as much about how clean it is under your bed as you might do, and this person might not put as much effort into cleaning there (especially if you can’t check it easily) than you might like them to.

Anyway, in our case, a 200% interest rate agreement might well lead to moral hazard and a resulting increase in the probability of the project being unsuccessful. This might even be so severe that the investor might refuse this 200% interest rate.